Tuesday, May 8, 2012By Sonya Dowsett, Reuters

MADRID--To watchers of Spain's deeply troubled economy it was a symbolic moment — Prime Minister Mariano Rajoy posing for photos with the chairman of Bankia, one of its biggest banks, then walking away deep in conversation.

For Rajoy, the photo call in front of Bankia's logo at a recent conference was a show of support for the bank's Chairman Rodrigo Rato, a political ally. Yet it also highlighted their interdependence.

Bankia, which holds around 10 percent of Spanish deposits and is highly exposed to a devastating property crash, is at the core of concerns over whether the country will have to seek an Ireland-style international bail-out to recapitalise lenders.

Investors fret the bank will not be able to recapitalise loans to housebuilders and repossessed property in a recession without a large injection of public money. But the political ties of the former savings bank complicate matters.

“If you want to solve Bankia, you shut it down. But the government is not considering that — it is so ingrained in the political system,” said one Spanish banker involved with savings bank restructuring.

Certainly there is no shortage of links between the bank and Spain's governing People's Party (PP).

Bankia Chairman Rato was economy minister from 1996 to 2004 under a previous PP administration, before leaving Spain for a time to head up the International Monetary Fund (IMF).

Rato was a potential successor to former PP Prime Minister Jose Maria Aznar before being pipped to the post by Rajoy. He is a proud man who banking sources say would do anything to prevent his bank being nationalised.

Nonetheless Bankia has already received 4.5 billion euros (US$5.9 billion) in state loans and the Economy Ministry and Bank of Spain are working towards a further solution for the bank, a government source said.

Market watchers envisage a number of alternative solutions: a break up the group to sell it off in pieces; a merger with another bank; or a state takeover. The creation of a “bad bank” holding company for toxic real estate assets is also an option being explored by the government.

Spain's banks as a whole have until May 31 to say if they will need to merge with other entities under a reform plan presented two months ago to clean up the sector.

Bankia, around a quarter of the size of Spain's largest bank Santander, declined to comment on whether it was in talks with authorities.

The lender has consistently maintained it is able to continue as an independent bank and has no problems in terms of solvency or liquidity. However, it has not ruled out mergers.

“We are in a robust position from the point of view of solvency and the point of view of liquidity,” Rato said at a recent event in Madrid. The Bank of Spain approved all Spanish banks' plans to boost capital last month, including Bankia's.

This has not convinced the IMF, which alluded to Bankia without naming it in a recent report on Spain's banking sector. It pinpointed a group of 10 banks, most of which have received state money, as vulnerable.

“To preserve financial stability, it is critical that these banks, especially the largest one, take swift and decisive measures to strengthen their balance sheets and improve management and governance practices,” the IMF said in a reference to Bankia.